UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 2005 ------------------ OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from _____________to ________________ Commission file number 0-6233 1st SOURCE CORPORATION (Exact name of registrant as specified in its charter) INDIANA 35-1068133 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 100 North Michigan Street South Bend, Indiana 46601 (Address of principal executive offices) (Zip Code) (574) 235-2000 (Registrant's telephone number, including area code) Not Applicable (Former name, former address and former fiscal year, if changed since last report.) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No______ Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes X No ______ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes __ No X Number of shares of common stock outstanding as of October 21, 2005 - 20,670,029 shares
TABLE OF CONTENTS PART I. FINANCIAL INFORMATION Page Item 1. Financial Statements (Unaudited) Consolidated statements of financial condition -- September 30, 2005, and December 31, 2004 3 Consolidated statements of income -- three months and nine months ended September 30, 2005 and 2004 4 Statement of changes in shareholders' equity - - nine months ended September 30, 2005 and 2004 5 Consolidated statements of cash flows -- nine months ended September 30, 2005 and 2004 Notes to the Consolidated Financial Statements 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 11 Item 3. Quantitative and Qualitative Disclosures About Market Risk 20 Item 4. Controls and Procedures 20 PART II. OTHER INFORMATION Item 1. Legal Proceedings 20 Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 21 Item 3. Defaults Upon Senior Securities 21 Item 4. Submission of Matters to a Vote of Security Holders 21 Item 5. Other Information 21 Item 6. Exhibits 22 SIGNATURES 2
<TABLE> <CAPTION> 1st SOURCE CORPORATION CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION (Unaudited - Dollars in thousands) September 30, December 31, 2005 2004 ------------- ------------- <S> <C> <C> ASSETS Cash and due from banks $ 78,538 $ 78,255 Federal funds sold and interest bearing deposits with other banks 1,370 220,131 Investment securities available-for-sale (amortized cost of $644,252 and $790,404 at September 30, 2005 and December 31, 2004, respectively) 639,628 789,923 Mortgages held for sale 126,457 55,711 Loans and leases - net of unearned discount Commercial and agricultural loans 426,316 425,018 Auto, light truck and environmental equipment 316,882 263,637 Medium and heavy duty truck 297,896 267,834 Aircraft financing 431,883 444,481 Construction equipment financing 206,220 196,516 Loans secured by real estate 589,217 583,437 Consumer loans 111,490 99,245 ------------- ------------- Total loans and leases 2,379,904 2,280,168 Reserve for loan and lease losses (58,547) (63,672) ----------------------------- Net loans and leases 2,321,357 2,216,496 Equipment owned under operating leases, net of accumulated depreciation 51,544 47,257 Net premises and equipment 37,426 37,314 Accrued income and other assets 114,106 118,628 ----------------------------- Total assets $ 3,370,426 $ 3,563,715 ============================= LIABILITIES Deposits: Noninterest bearing $ 392,312 $ 378,867 Interest bearing 2,202,489 2,428,136 ----------------------------- Total deposits 2,594,801 2,807,003 Federal funds purchased and securities sold under agreements to repurchase 187,507 216,751 Other short-term borrowings 113,717 82,911 Long-term debt and mandatorily redeemable securities 18,191 17,964 Subordinated notes 59,022 59,022 Accrued expenses and other liabilities 57,616 53,464 ----------------------------- Total liabilities 3,030,854 3,237,115 SHAREHOLDERS' EQUITY Preferred stock; no par value - - Common stock; no par value Authorized 40,000,000 shares; issued 21,617,073 at September 30, 2005 and 21,617,057 at December 31, 2004 7,578 7,578 Capital surplus 214,001 214,001 Retained earnings 133,188 115,830 Cost of common stock in treasury (12,343) (10,512) Accumulated other comprehensive loss (2,852) (297) ------------- ------------- Total shareholders' equity 339,572 326,600 ----------------------------- Total liabilities and shareholders' equity $ 3,370,426 $ 3,563,715 ============= ============= </TABLE> The accompanying notes are a part of the consolidated financial statements. 3
<TABLE> <CAPTION> 1st SOURCE CORPORATION CONSOLIDATED STATEMENTS OF INCOME (Unaudited - Dollars in thousands, except per share amounts) Three Months Ended Nine Months Ended September 30, September 30, ------------------------------------------------------------ 2005 2004 2005 2004 ------------------------------------------------------------ <S> <C> <C> <C> <C> Interest income: Loans and leases $ 38,781 $ 32,144 $ 107,883 $ 96,502 Investment securities, taxable 3,501 3,793 11,234 12,188 Investment securities, tax-exempt 1,342 1,260 3,942 3,835 Other 33 23 237 134 ------------------------------------------------------------ Total interest income 43,657 37,220 123,296 112,659 Interest expense: Deposits 14,452 9,833 40,098 29,253 Short-term borrowings 2,586 1,826 6,294 4,366 Subordinated notes 1,015 975 2,979 2,898 Long-term debt and mandatorily redeemable securities 305 363 820 823 ------------------------------------------------------------ Total interest expense 18,358 12,997 50,191 37,340 ------------------------------------------------------------ Net interest income 25,299 24,223 73,105 75,319 (Recovery of)/provision for loan and lease losses (1,304) 237 (5,136) 820 ------------------------------------------------------------ Net interest income after (recovery of)/provision for loan and lease losses 26,603 23,986 78,241 74,499 Noninterest income: Trust fees 3,139 3,072 9,670 9,302 Service charges on deposit accounts 4,656 4,272 12,870 12,093 Mortgage banking income 3,816 (828) 8,134 4,517 Equipment rental income 4,108 4,270 12,050 15,021 Other income 2,706 3,364 7,885 7,747 Investment securities and other investment gains (losses) (559) (3,744) 350 (4,034) ------------------------------------------------------------ Total noninterest income 17,866 10,406 50,959 44,646 ------------------------------------------------------------ Noninterest expense: Salaries and employee benefits 17,663 16,622 53,297 48,242 Net occupancy expense 1,848 1,764 5,682 5,322 Furniture and equipment expense 2,958 2,416 8,444 7,697 Depreciation - leased equipment 3,207 3,533 9,724 11,952 Supplies and communication 1,417 1,396 4,081 4,279 Loan and lease collection and repossession expense (1,132) 1,313 (948) 3,189 Other expense 4,322 5,330 12,303 15,980 ------------------------------------------------------------ Total noninterest expense 30,283 32,374 92,583 96,661 ------------------------------------------------------------ Income before income taxes 14,186 2,018 36,617 22,484 Income tax expense/(benefit) 4,705 (1,290) 11,965 5,379 ------------------------------------------------------------ Net income $ 9,481 $ 3,308 $ 24,652 $ 17,105 ============================================================ Other comprehensive income/(loss), net of tax: Change in unrealized (depreciation) appreciation of available-for-sale securities (916) 7,045 (2,555) (549) ------------------------------------------------------------ Total comprehensive income $ 8,565 $ 10,353 $ 22,097 $ 16,556 ============================================================ Per common share: Basic net income per common share $ 0.46 $ 0.16 $ 1.19 $ 0.83 ============================================================ Diluted net income per common share $ 0.45 $ 0.16 $ 1.18 $ 0.82 ============================================================ Dividends declared $ 0.130 $ 0.110 $ 0.370 $ 0.310 ============================================================ Basic weighted average common shares outstanding 20,670,080 20,682,707 20,691,425 20,703,344 ============================================================ Diluted weighted average common shares outstanding 20,945,912 20,953,401 20,959,301 20,968,643 ============================================================ </TABLE> The accompanying notes are a part of the consolidated financial statements. 4
<TABLE> <CAPTION> 1st SOURCE CORPORATION CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY (Unaudited - Dollars in thousands, except per share amounts) - ------------------------------------------------------------------------------------------------------------------------------ Net Unrealized Appreciation Cost of (Depreciation) Common of Securities Common Capital Retained Stock Available- Total Stock Surplus Earnings in Treasury For-Sale - ------------------------------------------------------------------------------------------------------------------------------ <S> <C> <C> <C> <C> <C> <C> Balance at January 1, 2004 $314,691 $7,578 $214,001 $100,534 ($ 9,777) $ 2,355 - ------------------------------------------------------------------------------------------------------------------------------ Comprehensive Income, net of tax: Net Income 17,105 - - 17,105 - - Change in unrealized depreciation of available-for-sale securities, net of tax (549) - - - - (549) --------- Total Comprehensive Income 16,556 - - - - - Issuance of 222,532 common shares under stock based compensation plans, including related tax effects 3,177 - - (976) 4,153 - Cost of 213,884 shares of common stock acquired for treasury (4,947) - - - (4,947) - Cash dividend ($0.31 per share) (6,419) - - (6,419) - - - ------------------------------------------------------------------------------------------------------------------------------ Balance at September 30, 2004 $323,058 $7,578 $214,001 $110,244 ($10,571) $1,806 ============================================================================================================================== Balance at January 1, 2005 $326,600 $7,578 $214,001 $115,830 ($10,512) ($297) - ------------------------------------------------------------------------------------------------------------------------------ Comprehensive Income, net of tax: Net Income 24,652 - - 24,652 - - Change in unrealized depreciation of available-for-sale securities, net of tax (2,555) - - - - (2,555) --------- Total Comprehensive Income 22,097 - - - - - Issuance of 51,383 common shares under stock based compensation plans, including related tax effects 539 - - 158 381 - Cost of 110,581 shares of common stock acquired for treasury (2,212) - - - (2,212) - Cash dividend ($0.36 per share) (7,452) - - (7,452) - - - ------------------------------------------------------------------------------------------------------------------------------ Balance at September 30, 2005 $339,572 $7,578 $214,001 $133,188 ($12,343) ($2,852) ============================================================================================================================== </TABLE> The accompanying notes are a part of the consolidated financial statements. 5
<TABLE> <CAPTION> 1st SOURCE CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited - Dollars in thousands) Nine Months Ended September 30, ------------------------------------- 2005 2004 ------------------------------------- <S> <C> <C> Operating activities: Net income $ 24,652 $ 17,105 Adjustments to reconcile net income to net cash (used in)/from operating activities: (Recovery of) Provision for loan and lease losses (5,136) 820 Depreciation of premises and equipment 13,514 15,556 Amortization of investment security premiums and accretion of discounts, net 3,580 4,982 Amortization of mortgage servicing rights 5,332 5,681 Mortgage servicing asset impairment (recoveries) charges (2,170) 1,954 Deferred income taxes 3,685 2,959 Realized investment securities (gains) losses (350) 365 Change in mortgages held for sale (70,746) (14,038) Change in trading account securities - (4,926) Change in interest receivable (183) 611 Change in interest payable 1,777 (473) Change in other assets 1,543 (1,861) Change in other liabilities 276 (7,041) Other 362 3,751 ------------------------------------- Net cash (used in)/from operating activities (23,864) 25,445 Investing activities: Proceeds from sales and maturities of investment securities 243,225 170,424 Purchases of investment securities (100,302) (194,120) Net change in short-term investments 218,760 (51,579) Loans sold or participated to others (18) - Net change in loans and leases (99,706) (46,907) Net change in equipment owned under operating leases (14,010) 10,899 Purchases of premises and equipment (4,052) (2,737) ------------------------------------- Net cash from/(used in) investing activities 243,897 (114,020) Financing activities: Net change in demand deposits, NOW accounts and savings accounts (329,120) (48,906) Net change in certificates of deposit 116,918 15,912 Net change in short-term borrowings 1,562 87,158 Proceeds from issuance of long-term debt 361 500 Proceeds from issuance of subordinated notes - 30,929 Payments on subordinated notes - (28,351) Payments on long-term debt (210) (301) Net proceeds from issuance of treasury stock 540 3,177 Acquisition of treasury stock (2,212) (4,947) Cash dividends (7,589) (6,541) ------------------------------------- Net cash (used in) from financing activities (219,750) 48,630 Net change in cash and cash equivalents 283 (39,945) Cash and cash equivalents, beginning of period 78,255 109,787 ------------------------------------- Cash and cash equivalents, end of period $ 78,538 $ 69,842 ===================================== </TABLE> The accompanying notes are a part of the consolidated financial statements. 6
1ST SOURCE CORPORATION NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) Note 1. Basis of Presentation The accompanying unaudited consolidated financial statements reflect all adjustments (all of which are normal and recurring in nature) that are, in the opinion of management, necessary for a fair presentation of the consolidated financial condition, the results of operations, changes in shareholders' equity, and cash flows for the periods presented. These unaudited consolidated financial statements have been prepared according to the rules and regulations of the Securities and Exchange Commission (SEC) and, therefore, certain information and footnote disclosures normally included in financial statements prepared in accordance with U. S. generally accepted accounting principles have been omitted. The Notes to the Consolidated Financial Statements appearing in 1st Source Corporation's (1st Source) Annual Report on Form 10-K (2004 Annual Report), which include descriptions of significant accounting policies, should be read in conjunction with these interim financial statements. The balance sheet at December 31, 2004, has been derived from the audited financial statements at that date, but does not include all of the information and footnotes required by U. S. generally accepted accounting principles for complete financial statements. Certain amounts in the prior period consolidated financial statements have been reclassified to conform with the current year presentation. 1st Source accounts for its stock-based compensation plans under the recognition and measurement principles provided in Accounting Principles Board Opinion (APB) No. 25, "Accounting for Stock Issued to Employees," and related Interpretations. Stock-based employee compensation expense for the Executive Incentive Plan and the Restricted Stock Award Plan is recognized in net income. For the stock option plans, the stock option agreement, and the Employee Stock Purchase Plan, no compensation expense is recognized in net income as all options granted under these plans had an exercise price equal to the market value of the underlying common stock on the date of grant. Statement of Financial Accounting Standards (SFAS) No. 123, "Accounting for Stock-Based Compensation," as amended by SFAS No.148, requires pro forma disclosures of net income and earnings per share for companies not adopting its fair value accounting method for stock-based employee compensation. The pro forma disclosures presented in Note 6 - Stock-Based Compensation use the fair value method of SFAS No. 123 to measure compensation expense for stock-based employee compensation plans. Note 2. Recent Accounting Pronouncements Meaning of Other-Than-Temporary Impairment: In June 2005, the FASB directed its staff to draft FSP SFAS No. 115-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments." FSP 115-1 will codify the guidance set forth in EITF Topic D-44 and clarify that an investor should recognize an impairment loss no later than when the impairment is deemed other-than-temporary, even if the decision to sell has not been made. FSP SFAS No. 115-1 will be effective for other-than-temporary impairment analysis conducted for fiscal years beginning after December 15, 2005. The issuance of the final FSP will not have a material impact on the financial condition, the results of operations, or liquidity of 1st Source. Accounting Changes and Error Corrections: In May 2005, the FASB issued SFAS No. 154, "Accounting for Changes and Error Corrections," which changes the accounting for and reporting of a change in accounting principle. This statement also applies to all voluntary changes in accounting principle and changes 7
required by an accounting pronouncement in the unusual instance that the pronouncement does not include specific transition provisions. This statement requires retrospective application to prior period financial statements of changes in accounting principle, unless it is impractical to determine either the period - specific or cumulative effects of the change. SFAS No. 154 is effective for accounting changes made in fiscal years beginning after December 15, 2005. The adoption of this standard is not expected to have a material effect on the financial condition, the results of operations or liquidity of 1st Source. Exchanges of Nonmonetary Assets: In December 2004, the FASB issued SFAS No. 153, "Exchanges of Nonmonetary Assets, an amendment to APB Opinion No. 29, "Accounting for Nonmonetary Transactions." This statement amends the principle that exchanges of nonmonetary assets should be measured based on the fair value of the assets exchanged and more broadly provides for exceptions regarding exchanges of nonmonetary assets that do not have commercial substance. This Statement is effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June 15, 2005. The adoption of this standard did not have a material impact on the financial condition, results of operation, or liquidity of 1st Source. Accounting for Stock-Based Compensation: On December 16, 2004, the FASB issued SFAS No. 123(R), "Share-Based Payment", which is a revision of SFAS No. 123, "Accounting for Stock-Based Compensation." SFAS No. 123(R) supersedes APB No. 25, "Accounting for Stock Issued to Employees," and amends SFAS No. 95, "Statement of Cash Flows." Generally, the approach in SFAS No. 123(R) is similar to the approach described in SFAS No. 123. However, SFAS No. 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative. Originally, SFAS No. 123(R) was required to be adopted no later than July 1, 2005. On April 14, 2005, the SEC issued an amendment to SFAS No. 123(R), which allows companies to implement SFAS 123(R) at the beginning of their next fiscal year, instead of the next reporting period, that begins after June 15, 2005. The new rule does not change the accounting required by SFAS No. 123(R), but does change the dates for compliance with the standard. Early adoption is permitted in periods in which financial statements have not yet been issued. 1st Source expects to adopt SFAS No. 123(R) on January 1, 2006. SFAS No. 123(R) permits public companies to adopt its requirements using one of two methods: 1. A "modified prospective" method in which compensation cost is recognized beginning with the effective date (a) based on the requirements of SFAS No. 123(R) for all share-based payments granted after the effective date, and (b) based on the requirements of SFAS No. 123 for all awards granted to employees prior to the effective date of SFAS No. 123(R) that remain unvested on the effective date. 2. A "modified retrospective" method which includes the requirements of the modified prospective method described above, but also permits entities to restate based on the amounts previously recognized under SFAS No. 123 for purposes of pro forma disclosures either (a) all prior periods presented, or (b) prior interim periods of the year of adoption. 1st Source has not made a determination as to which method it will utilize upon adoption of SFAS No. 123(R). As permitted by SFAS No. 123, 1st Source currently accounts for share-based payments to employees using APB Opinion No. 25's intrinsic value method and, as such, generally recognizes no compensation cost for employee stock options. Accordingly, the adoption of SFAS No. 123(R)'s fair value method may have a significant impact on our results of operations, although it will have no significant impact on our overall financial position. 8
The impact of adoption of SFAS No. 123(R) cannot be predicted at this time because it will depend on levels of share-based payments granted in the future. However, had we adopted SFAS No. 123(R) in prior periods, the impact of the standard would have approximated the impact of SFAS No. 123 as described in the disclosure of pro forma net income and earnings per share in Note 5 of the consolidated financial statements. SFAS No. 123(R) also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after adoption. 1st Source cannot estimate what those amounts will be in the future (because they depend on, among other things, when employees exercise stock options). Note 3. Investments Other-Than-Temporary Impairment 1st Source recognized a $0.61 million and $3.67 million non-cash pre-tax charge to expense for its investments in floating rate preferred stock issued by the Federal National Home Mortgage Association (FNMA) and the Federal Home Loan Mortgage Corporation (FHLMC) in the quarters ended September 30, 2005 and 2004, respectively. 1st Source accounts for these securities in accordance with FASB No. 115, which states that if the decline in fair market value below cost is determined to be other-than-temporary, the unrealized loss must be realized as expense in the income statement. Based on a number of factors, including the magnitude of the decline in the market value and the length of time the market value had been below cost, 1st Source concluded that the decline in value was other-than-temporary. Accordingly, the other-than-temporary impairment was recognized in the income statement. Note 4. Reserve for Loan and Lease Losses The reserve for loan and lease losses is maintained at a level believed to be adequate by management to absorb probable losses inherent in the loan and lease portfolio. The determination of the reserve requires significant judgment reflecting management's best estimate of probable loan and lease losses related to specifically identified loans and leases as well as probable losses in the remainder of the various loan and lease portfolios. The methodology for assessing the appropriateness of the reserve consists of several key elements, which include: specific reserves for identified special attention loans and leases (substandard loans and leases and internal watch list credits), percentage allocations for special attention loans and leases without specific reserves, formula reserves for each business lending division portfolio, including a higher percentage reserve allocation for special attention loans and leases without a specific reserve, and reserves for pooled homogenous loans and leases. Management's evaluation is based upon a continuing review of these portfolios, estimates of future customer performance, collateral values and dispositions and consideration of current economic trends, all of which are subject to judgment and will change. Note 5. Financial Instruments with Off-Balance-Sheet Risk To meet the financing needs of its customers, 1st Source and its subsidiaries are parties to financial instruments with off-balance-sheet risk in the normal course of business. These off-balance-sheet financial instruments include commitments to originate, purchase and sell loans and standby letters of credit. The instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated statements of financial condition. 1st Source's exposure to credit loss in the event of nonperformance by the other party to the financial instruments for loan commitments and standby letters of credit is represented by the dollar amount of those instruments. 1st Source uses the same credit policies and collateral requirements in making commitments and conditional obligations as it does for on-balance-sheet instruments. 9
Trustcorp Mortgage Company and 1st Source Bank (Bank), subsidiaries of 1st Source, grant mortgage loan commitments to borrowers, subject to normal loan underwriting standards. The interest rate risk associated with these loan commitments is managed by entering into contracts for future deliveries of loans. Loan commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. The credit risk involved and collateral obtained in issuing letters of credit is essentially the same as that involved in extending loan commitments to customers. As of September 30, 2005, and December 31, 2004, 1st Source had commitments outstanding to originate and purchase mortgage loans aggregating $205.41 million and $106.61 million, respectively. Outstanding commitments to sell mortgage loans aggregated $182.44 million at September 30, 2005, and $83.82 million at December 31, 2004. Standby letters of credit totaled $72.42 million and $90.67 million at September 30, 2005, and December 31, 2004, respectively. Standby letters of credit have terms ranging from six months to one year. Note 6. Stock-Based Compensation The following pro forma information presents net income and earnings per share for the three and nine month periods ended September 30, 2005, and 2004 as if the fair value method of SFAS No. 123, "Accounting for Stock-Based Compensation," as amended by SFAS No. 148, had been used to measure compensation cost for stock-based compensation plans. For the purposes of these pro forma disclosures, the estimated fair value of stock options and restricted stock awards is amortized to expense over the related vesting periods. <TABLE> <CAPTION> Three Months Ended Nine Months Ended September 30, September 30, 2005 2004 2005 2004 ----------------------------------------------- <S> <C> <C> <C> <C> Net income, as reported (000's) $9,481 $3,308 $24,652 $17,105 Add: Stock-based employee compensation expense included in reported net income, net of related tax effects 685 401 2,227 1,137 Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects (701) (430) (2,333) (1,304) ------ ------ -------- -------- Pro forma net income $9,465 $3,279 $24,546 $16,938 ====== ====== ======= ======= Earnings per share: Basic - as reported $0.46 $0.16 $1.19 $0.83 ===== ===== ===== ===== Basic - pro forma $0.46 $0.16 $1.19 $0.82 ===== ===== ===== ===== Diluted - as reported $0.45 $0.16 $1.18 $0.82 ===== ===== ===== ===== Diluted - pro forma $0.45 $0.16 $1.17 $0.81 ===== ===== ===== ===== </TABLE> 10
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Except for historical information contained herein, the matters discussed in this document express "forward-looking statements." Generally, the words "believe," "expect," "intend," "estimate," "anticipate," "project," "will" and similar expressions indicate forward-looking statements. Those statements, including statements, projections, estimates or assumptions concerning future events or performance, and other statements that are other than statements of historical fact, are subject to material risks and uncertainties. 1st Source cautions readers not to place undue reliance on any forward-looking statements, which speak only as of the date made. 1st Source may make other written or oral forward-looking statements from time to time. Readers are advised that various important factors could cause 1st Source's actual results or circumstances for future periods to differ materially from those anticipated or projected in such forward-looking statements. Such factors include, but are not limited to, changes in law, regulations or U. S. generally accepted accounting principles; 1st Source's competitive position within its markets served; increasing consolidation within the banking industry; unforeseen changes in interest rates; unforeseen changes in loan prepayment assumptions; unforeseen downturns in or major events affecting the local, regional or national economies or the industries in which 1st Source has credit concentrations; and other matters discussed in 1st Source's filings with the SEC, including its Annual Report on Form 10-K for 2004, which filings are available from the SEC. 1st Source undertakes no obligation to publicly update or revise any forward-looking statements. The following management's discussion and analysis is presented to provide information concerning the financial condition of 1st Source as of September 30, 2005, as compared to December 31, 2004, and the results of operations for the three and nine months ended September 30, 2005, and 2004. This discussion and analysis should be read in conjunction with 1st Source's consolidated financial statements and the financial and statistical data appearing elsewhere in this report and 1st Source's 2004 Annual Report. FINANCIAL CONDITION 1st Source's assets at September 30, 2005, were $3.37 billion, down 5.42% from December 31, 2004. Total loans and leases increased 4.37% and total deposits decreased 7.56% from comparable figures at the end of 2004. Nonperforming assets at September 30, 2005, were $21.65 million compared to $33.21 million at December 31, 2004, a decrease of 34.81%. The year-to-date decrease was primarily the result of a decrease in aircraft and commercial and agricultural nonaccrual loans and liquidation of repossessions. At September 30, 2005, nonperforming assets were 0.89% of net loans and leases compared to 1.42% at December 31, 2004. Accrued income and other assets were as follows: 11
(Dollars in thousands) September 30, December 31, 2005 2004 --------------------------- Accrued income and other assets: Bank owned life insurance cash surrender value $ 34,431 $ 33,552 Accrued interest receivable 12,688 12,505 Mortgage servicing assets 21,768 21,414 Other real estate 940 1,878 Repossessions 368 4,382 Intangible assets 22,087 23,588 All other assets 21,824 21,309 --------------------------- Total accrued income and other assets $ 114,106 $ 118,628 =========================== CAPITAL As of September 30, 2005, total shareholders' equity was $339.57 million, up 3.97% from the $326.60 million at December 31, 2004. In addition to net income of $24.65 million, other significant changes in shareholders' equity during the first nine months of 2005 included $2.21 million in treasury stock purchases, and $7.45 million of dividends paid. The accumulated other comprehensive loss component of shareholders' equity totaled $2.85 million at September 30, 2005, compared to $0.30 million at December 31, 2004. The increase in accumulated other comprehensive loss was a result of changes in unrealized gain or loss on securities in the available-for-sale portfolio. The 1st Source equity-to-assets ratio was 10.08% as of September 30, 2005, compared to 9.16% at December 31, 2004. Book value per common share rose to $16.43 at September 30, 2005, up from $15.76 at December 31, 2004. 1st Source declared and paid dividends per common share of $0.12 during the third quarter of 2005. The trailing four quarters dividend payout ratio was 37.60%. The dividend payout is continually reviewed by management and the Board of Directors. The banking regulators have established guidelines for leverage capital requirements, expressed in terms of Tier 1 or core capital as a percentage of average assets, to measure the soundness of a financial institution. In addition, banking regulators have established risk-based capital guidelines for U.S. banking organizations. The actual capital amounts and ratios of 1st Source and its largest subsidiary, the Bank, as of September 30, 2005, are presented in the table below: <TABLE> <CAPTION> To Be Well Capitalized Under Minimum Capital Prompt Corrective Actual Adequacy Action Provisions (Dollars in thousands) Amount Ratio Amount Ratio Amount Ratio - -------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> <C> Total Capital (To Risk-Weighted Assets): Consolidated $413,521 15.06 % $219,731 8.00 % $274,664 10.00 % 1st Source Bank 388,536 14.46 214,919 8.00 268,649 10.00 Tier 1 Capital (to Risk-Weighted Assets): Consolidated 377,587 13.75 109,866 4.00 164,798 6.00 1st Source Bank 354,501 13.20 107,460 4.00 161,189 6.00 Tier 1 Capital (to Average Assets): Consolidated 377,587 11.17 135,261 4.00 169,076 5.00 1st Source Bank 354,501 10.75 131,868 4.00 164,835 5.00 </TABLE> 12
LIQUIDITY AND INTEREST RATE SENSITIVITY The Bank's liquidity is closely monitored and managed by the Asset/Liability Committee (ALCO), which is comprised of the Bank's senior management. Asset and liability management includes the management of interest rate sensitivity and the maintenance of an adequate liquidity position. The purpose of interest rate sensitivity management is to stabilize net interest income during periods of changing interest rates. Liquidity management is the process by which the Bank ensures that adequate liquid funds are available to meet financial commitments on a timely basis. Financial institutions must maintain liquidity to meet day-to-day requirements of depositors and borrowers, take advantage of market opportunities and provide a cushion against unforeseen needs. Liquidity of the Bank is derived primarily from core deposits, principal payments received on loans, the sale and maturity of investment securities, net cash provided by operating activities, and access to other funding sources. The most stable source of liability funded liquidity is deposit growth and retention of the core deposit base. The principal sources of asset funded liquidity are available-for-sale investment securities, cash and due from banks, federal funds sold, securities purchased under agreements to resell and loans and interest bearing deposits with other banks maturing within one year. Additionally, liquidity is provided by bank lines of credit, repurchase agreements and the ability to borrow from the Federal Reserve Bank and Federal Home Loan Bank. 1st Source's ALCO monitors and manages the relationship of earning assets to interest bearing liabilities and the responsiveness of asset yields, interest expense, and interest margins to changes in market interest rates. At September 30, 2005, the consolidated statement of financial condition was rate-sensitive by $31.00 million more liabilities than assets scheduled to reprice within one year or approximately 0.98%. RESULTS OF OPERATIONS Net income for the three- and nine-month periods ended September 30, 2005, was $9.48 million and $24.65 million respectively, compared to $3.31 million and $17.11 million for the same periods in 2004. Diluted net income per common share was $0.45 and $1.18 respectively, for the three- and nine-month periods ended September 30, 2005, compared to $0.16 and $0.82 for the same periods in 2004. Return on average common shareholders' equity was 9.97% for the nine months ended September 30, 2005, compared to 7.19% in 2004. The return on total average assets was 0.98% for the nine months ended September 30, 2005, compared to 0.70% in 2004. The increase in net income for the nine months ended September 30, 2005, over the first nine months of 2004, was primarily the result of a favorable change in the provision for loan and lease losses which resulted in a $5.96 million recovery and a $4.08 million decrease in noninterest expense, which was partially offset by a $2.21 million decrease in net interest income. Details of the changes in the various components of net income are further discussed below. NET INTEREST INCOME The taxable-equivalent net interest income for the three months ended September 30, 2005, was $25.98 million, up 4.39% from the previous quarter and up 4.32% from the comparable period in 2004. The taxable-equivalent net interest income for the nine months ended September 30, 2005, was $75.11 million, a decrease of 2.94% from the same period in 2004. The net interest margin on a fully taxable-equivalent basis was 3.24% for the three months ended September 30, 2005, compared to 3.18% for the preceding quarter and the three months ended September 30, 2004. The net interest margin on a fully taxable-equivalent basis was 3.19% for the nine months ended September 30, 2005, compared to 3.39% for the nine months ended September 30, 2004. The continued rise in short term interest rates has flattened the yield curve and resulted in continued compression of the net interest margin for the nine months ended 2005. 13
Total average earning assets increased 2.25% and 3.17%, respectively, for the three- and nine-month periods ended September 30, 2005, over the comparative periods in 2004. Average loans and leases outstanding increased 6.10% and 5.29% for the three- and nine-month periods, compared to the same periods in 2004, due to increased loan outstandings in auto and light truck financings and medium and heavy duty truck financings. Total average investment securities decreased 14.24% and 4.04% for the three- and nine-month periods over one year ago due to a decrease in United States Treasury and agency securities and other equity investments as maturities in the investment portfolio were used to fund loan growth. For the nine-month period, average mortgages held for sale increased 18.63%, as the timing of sales of mortgage loans into the secondary market lagged slightly during the third quarter of 2005. Other investments, which include Federal funds sold, time deposits with other banks and trading account securities, decreased for the three- and nine-month periods over 2004 as availability of excess funds used for investment purposes decreased due to loan growth. The taxable-equivalent yields on total average earning assets were 5.53% and 4.85% for the three month periods ended September 30, 2005 and 2004, respectively, and 5.32% and 5.02% for the nine month periods ended September 30, 2005 and 2004, respectively. Average interest-bearing deposits increased 8.72% and 8.21% for the three- and nine-month periods, ended September 30, 2005, over the same periods in 2004. The rates on average interest-bearing funds were 2.80% and 2.01% for the three months ended September 30, 2005 and 2004. For the nine months ended September 30, 2005 and 2004, the rates on average interest bearing funds were 2.59% and 1.97%, respectively. The cost of deposits was 2.60% for the third quarter of 2005, an increase of approximately 67 basis points as compared to the third quarter 2004. The cost of borrowed Federal funds and other short-term borrowings was 3.21% for the third quarter of 2005, an increase of approximately 165 basis points as compared to the third quarter 2004. The Federal Reserve Board has increased the short term rates by 250 basis points since June 2004. The following table sets forth consolidated information regarding average balances and rates. 14
<TABLE> <CAPTION> DISTRIBUTION OF ASSETS, LIABILITIES AND SHAREHOLDERS' EQUITY INTEREST RATES AND INTEREST DIFFERENTIAL (Dollars in thousands) Three months ended September 30, 2005 2004 ------------------------------- -------------------------------- Interest Interest Average Income/ Yield/ Average Income/ Yield/ Balance Expense Rate Balance Expense Rate ------------------------------- -------------------------------- <S> <C> <C> <C> <C> <C> <C> ASSETS: Investment securities: Taxable $ 484,226 $ 3,501 2.87% $ 612,488 $ 3,793 2.46% Tax exempt (1) 189,764 1,952 4.08% 173,432 1,868 4.28% Mortgages - held for sale 119,529 1,701 5.65% 67,221 936 5.54% Net loans and leases (2 & 3) 2,382,251 37,146 6.19% 2,245,291 31,276 5.54% Other investments 4,318 33 3.03% 11,768 23 0.78% ------------------------------- -------------------------------- Total Earning Assets 3,180,088 44,333 5.53% 3,110,200 37,896 4.85% Cash and due from banks 84,364 83,698 Reserve for loan and lease losses (59,536) (69,921) Other assets 198,690 209,630 ------------- ------------- Total $ 3,403,606 $ 3,333,607 ============= ============= LIABILITIES AND SHAREHOLDERS' EQUITY: Interest-bearing deposits $ 2,206,176 $ 14,452 2.60% $ 2,029,141 $ 9,833 1.93% Short-term borrowings 319,964 2,586 3.21% 465,433 1,826 1.56% Subordinated notes 59,022 1,015 6.82% 56,864 975 6.82% Long-term debt and mandatorily redeemable securities 18,099 305 6.69% 22,866 363 6.32% ------------------------------- -------------------------------- Total Interest-Bearing Liabilities 2,603,261 18,358 2.80% 2,574,304 12,997 2.01% Noninterest-bearing deposits 403,146 388,332 Other liabilities 60,965 52,735 Shareholders' equity 336,234 318,236 ------------- ------------- Total $ 3,403,606 $ 3,333,607 ============= ============= -------- -------- Net Interest Income $ 25,975 $ 24,899 ======== ======== Net Yield on Earning Assets on a Taxable ----- ----- Equivalent Basis 3.24% 3.18% ===== ===== </TABLE> <TABLE> <CAPTION> DISTRIBUTION OF ASSETS, LIABILITIES AND SHAREHOLDERS' EQUITY INTEREST RATES AND INTEREST DIFFERENTIAL (Dollars in thousands) Nine months ended September 30, 2005 2004 ---------------------------------- ------------------------------------- Interest Interest Average Income/ Yield/ Average Income/ Yield/ Balance Expense Rate Balance Expense Rate ---------------------------------- ------------------------------------- <S> <C> <C> <C> <C> <C> <C> ASSETS: Investment securities: Taxable $ 537,838 $ 11,234 2.79% $ 584,070 $ 12,188 2.79% Tax exempt (1) 186,681 5,754 4.12% 170,918 5,695 4.45% Mortgages - held for sale 84,096 3,635 5.78% 70,892 2,915 5.49% Net loans and leases (2 & 3) 2,328,942 104,441 6.00% 2,212,015 93,797 5.66% Other investments 11,674 237 2.71% 14,508 134 1.23% ---------------------------------- ------------------------------------- Total Earning Assets 3,149,231 125,301 5.32% 3,052,403 114,729 5.02% Cash and due from banks 83,513 79,716 Reserve for loan and lease losses (61,922) (70,046) Other assets 196,800 218,774 -------------- ------------ Total $ 3,367,622 $ 3,280,847 ============== ============ LIABILITIES AND SHAREHOLDERS' EQUITY: Interest-bearing deposits $ 2,208,094 $ 40,098 2.43% $ 2,040,566 $ 29,253 1.91% Short-term borrowings 303,349 6,294 2.77% 406,101 4,366 1.44% Subordinated notes 59,022 2,979 6.75% 56,585 2,898 6.84% Long-term debt and mandatorily redeemable securities 18,017 820 6.09% 23,005 823 4.78% ------------------------------------- ---------------------------------- Total Interest-Bearing Liabilities 2,588,482 50,191 2.59% 2,526,257 37,340 1.97% Noninterest-bearing deposits 392,648 380,551 Other liabilities 55,755 56,167 Shareholders' equity 330,737 317,872 -------------- ------------ Total $ 3,367,622 $ 3,280,847 ============== ============ --------- -------- Net Interest Income $ 75,110 $ 77,389 ========= ======== Net Yield on Earning Assets on a Taxable ----- ----- Equivalent Basis 3.19% 3.39% ===== ===== </TABLE> (1) Interest income includes the effects of taxable equivalent adjustments, using a 35% rate. Tax equivalent adjustments for the three month period were $610 in 2005 and $608 in 2004 and for the nine month period were $1,812 in 2005 and $1,860 in 2004. (2) Loan and lease income includes fees on loans and leases for the three month period of ($203) in 2005 and $133 in 2004 and for the nine month period of ($730) in 2005 and $1,462 in 2004. Loan and lease income also includes the effects of taxable equivalent adjustments, using 35% rate for 2005 and 2004. The tax-equivalent adjustments for the three month period were $66 in 2005 and $68 in 2004 and for the nine month period were $193 in 2005 and $210 in 2004. (3) For purposes of this computation, nonaccruing loans and leases are included in the daily average loan and lease amounts outstanding. 15
PROVISION AND RESERVE FOR LOAN AND LEASE LOSSES The recovery of provision for loan and lease losses for the three-month and nine-month periods ended September 30, 2005 was $1.30 million and $5.14 million, respectively, as compared to the provision for loan and lease losses of $0.24 million and $0.82 million for the three-month and nine-month periods ended September 30, 2004, respectively. Net recoveries of $0.30 million were recorded for the third quarter 2005, compared to net charge-offs of $2.09 million for the same quarter a year ago. Year-to-date net recoveries of $0.01 million have been recorded in 2005, compared to net charge-offs of $2.68 million through September 2004. In the third quarter 2005, 1st Source continued to experience improvement in credit quality which led to a loan and lease loss reserve release during the quarter. Loan and lease delinquencies were 0.55% on September 30, 2005, as compared to 1.08% on September 30, 2004, and 0.70% at the end of 2004. The reserve for loan and lease losses as a percentage of loans and leases outstanding at the end of the period was 2.46% as compared to 3.00% one year ago and 2.79% at December 31, 2004. A summary of loan and lease loss experience during the three- and nine-month periods ended September 30, 2005 and 2004, is provided below. <TABLE> <CAPTION> Summary of Reserve for Loan and Lease Losses (Dollars in Thousands) Three Months Ended Nine Months Ended September 30, September 30, 2005 2004 2005 2004 --------- --------- --------- ---------- <S> <C> <C> <C> <C> Reserve for loan and lease losses - beginning balance $ 59,547 $ 70,045 $ 63,672 $ 70,045 Charge-offs (928) (2,632) (3,984) (7,059) Recoveries 1,232 539 3,995 4,383 --------- --------- --------- ---------- Net recoveries/(charge-offs) 304 (2,093) 11 (2,676) (Recovery of)/provision for loan and lease losses (1,304) 237 (5,136) 820 --------- --------- --------- ---------- Reserve for loan and lease losses - ending balance $ 58,547 $ 68,189 $ 58,547 $ 68,189 ========= ========= ========= ========== Loans and leases outstanding at end of period $ 2,379,904 $ 2,275,231 $ 2,379,904 $ 2,275,231 Average loans and leases outstanding during period 2,382,251 2,245,291 2,328,942 2,212,015 Reserve for loan and lease losses as a percentage of loans and leases outstanding at end of period 2.46% 3.00% 2.46% 3.00% Ratio of net recoveries/(charge-offs) during period to average loans and leases outstanding (0.05)% 0.37% 0.00% 0.16% </TABLE> 16
NONPERFORMING ASSETS Nonperforming assets were as follows: <TABLE> <CAPTION> (Dollars in thousands) September 30, December 31, September 30, 2005 2004 2004 --------------- ------------------ --------------- <S> <C> <C> <C> Loans and leases past due 90 days or more $ 373 $ 481 $ 361 Nonaccrual and restructured loans and leases 19,909 25,253 30,958 Other real estate 940 1,307 2,117 Repossessions 368 4,382 2,516 Equipment owned under operating leases 57 1,785 20 --------------- ------------------ --------------- Total nonperforming assets $ 21,647 $ 33,208 $ 35,972 =============== ================== =============== </TABLE> Nonperforming assets totaled $21.65 million at September 30, 2005, decreasing 34.81% from $33.21 million at December 31, 2004, and decreasing 39.82% from $35.97 million at September 30, 2004. The decrease during 2005 was primarily related to a decrease in aircraft and construction equipment nonaccrual loans and liquidation of repossessions. Nonperforming assets as a percentage of total loans and leases improved to 0.89% at September 30, 2005, from 1.42% at December 31, 2004 and 1.55% at September 30, 2004. As of September 30, 2005, the Bank had a $3.32 million standby letter of credit outstanding that supported bond indebtedness of a customer. Due to the current financial condition of the customer, if this standby letter of credit is funded, the Bank likely will foreclose on the real estate securing the customer's reimbursement obligation. This likely will result in an increase in other real estate for approximately the same amount as the funding. As of September 30, 2005, repossessions consisted of automobiles, light trucks, and environmental equipment. As of December 31, 2004 and September 30, 2004, repossessions also included aircraft and aircraft parts. At the time of repossession, unless the equipment is in the process of immediate sale, the recorded amount of the loan or lease is written down, if necessary, to the estimated value of the equipment or vehicle by a charge to the reserve for loan and lease losses. Any subsequent write-downs are included in noninterest expense. Supplemental Loan and Lease Information as of September 30, 2005 <TABLE> <CAPTION> (Dollars in thousands) Nonaccrual Other real estate Year-to-date Loans and leases and owned and net credit losses/ outstanding restructured loans repossessions recoveries -------------- --------------- --------------- ------------- <S> <C> <C> <C> <C> Commercial and agricultural loans $ 426,316 $ 4,157 $ - $ 107 Auto, light truck and environmental equipment 316,882 1,832 329 (201) Medium and heavy duty truck 297,896 62 15 (143) Aircraft financing 431,883 8,383 - (679) Construction equipment financing 206,220 3,595 - (1,545) Loans secured by real estate 589,217 1,402 940 34 Consumer loans 111,490 478 24 157 -------------- --------------- --------------- ------------- Total $ 2,379,904 $ 19,909 $ 1,308 $ (2,270) ============== =============== =============== ============= </TABLE> 17
For financial statements purposes, nonaccrual loans and leases are included in loan and lease outstandings, whereas repossessions and other real estate are included in other assets. Net credit losses include net charge-offs on loans and leases and valuation adjustments and gains and losses on disposition of repossessions and defaulted operating leases. NONINTEREST INCOME Noninterest income for the three month periods ended September 30, 2005 and 2004, was $17.87 million and $10.41 million, respectively, and $50.96 million and $44.65 million for the nine month periods ended September 30, 2005 and 2004, respectively. The predominant factors behind the increase in 2005 were an increase in mortgage banking income and decreased investment securities losses offset by decreased equipment rental income. <TABLE> <CAPTION> (Dollars in thousands) Three Months Ended Nine Months Ended September 30, September 30, 2005 2004 2005 2004 -------------------------------------------- <S> <C> <C> <C> <C> Noninterest income: Trust fees $ 3,139 $ 3,072 $ 9,670 $ 9,302 Service charges on deposit accounts 4,656 4,272 12,870 12,093 Mortgage banking income 3,816 (828) 8,134 4,517 Insurance commissions 1,099 933 3,096 2,658 Equipment rental income 4,108 4,270 12,050 15,021 Other income 1,607 2,431 4,789 5,089 Investment securities and other investment gains (losses) (559) (3,744) 350 (4,034) -------------------------------------------- Total noninterest income $ 17,866 $ 10,406 $ 50,959 $ 44,646 ============================================ </TABLE> Mortgage banking income fluctuations were mainly due to changes in mortgage servicing rights valuations which resulted in year-over-year mortgage servicing rights recoveries. For the three months ended September 30, 2005, mortgage servicing rights recovery was $1.56 million versus $2.51 million of mortgage servicing rights impairment for the same period in 2004. For the nine months ended September 30, 2005, mortgage servicing rights impairment recovery was $2.17 million versus $1.95 million of impairment for the same period in 2004. Trust fees, insurance commissions, and service charges on deposit accounts increased in both the three and nine month periods ended September 30, 2005, over the same periods in 2004. Trust fees increased due to growth in assets under management. Insurance commissions increased due to growth in commercial lines and higher premiums. Equipment rental income decreased for both the three and nine month periods ended September 30, 2005 over the same periods in 2004 due to the decrease in the operating lease portfolio. Other income on a year-over-year basis remained relatively stable. Other income decreased for the three month period ended September 30, 2005, over the same period in 2004, due to a reduction in trading security gains. During the third quarter of 2005 and 2004, 1st Source recognized a pre-tax other-than-temporary impairment for investments in FNMA and FHLMC preferred stock that totaled $0.61 million and $3.67 million, respectively. 1st Source accounts for these securities in accordance with SFAS No. 115. Under SFAS No. 115, if the decline in fair market value below cost is determined to be other-than-temporary, the unrealized loss must be realized as expense on the income statement. Based on a number of factors, including the magnitude of the drop in market value below 1st Source's cost and the length of time the market value had been below cost, 1st Source concluded that the decline in value was other than temporary. 18
NONINTEREST EXPENSE Noninterest expense for the three month periods ended September 30, 2005 and 2004, was $30.28 million and $32.37 million, respectively, and $92.58 million and $96.66 million for the nine month periods ended September 30, 2005 and 2004, respectively. The decrease in noninterest expense in 2005 was primarily due to decreased loan and lease collection and repossession expense, depreciation on leased equipment, and professional fees, partially offset by increased salaries and employee benefits. <TABLE> <CAPTION> (Dollars in thousands) Three Months Ended Nine Months Ended September 30, September 30, 2005 2004 2005 2004 --------------------------------------------- <S> <C> <C> <C> <C> Noninterest expense: Salaries and employee benefits $ 17,663 $ 16,622 $ 53,297 $ 48,242 Net occupancy expense 1,848 1,764 5,682 5,322 Furniture and equipment expense 2,958 2,416 8,444 7,697 Depreciation - leased equipment 3,207 3,533 9,724 11,952 Professional fees 1,206 1,370 2,690 5,336 Supplies and communication 1,417 1,396 4,081 4,279 Business development and marketing expense 637 822 2,157 2,478 Intangible asset amortization 668 659 1,996 1,973 Loan and lease collection and repossession expense (1,132) 1,313 (948) 3,189 Other expense 1,811 2,479 5,460 6,193 --------------------------------------------- Total noninterest expense $ 30,283 $ 32,374 $ 92,583 $ 96,661 ============================================== </TABLE> Salaries and employee benefits increased on a year-over-year basis primarily due to higher executive incentive and compensated absences accruals and increased group insurance costs. Loan and lease collection and repossession expense decreased as gains on the disposition of repossessed assets increased and valuation adjustments related to repossessed assets decreased. Third quarter and year-to-date net occupancy expense, furniture and equipment expense, supplies and communication, business development and marketing expense and intangible asset amortization, all remained comparable to 2004 levels. Leased equipment depreciation decreased due to the decrease in the operating lease portfolio. Professional fees decreased primarily due to a reduction of legal fees associated with the settlement, during the fourth quarter of 2004, of the lawsuit described in the 2003 Form 10-K Item 3, Legal Proceedings. Other expenses decreased on a year-over-year basis predominately due to the write-off of capitalized debt issuance costs related to the redemption of trust preferred securities during the third quarter of 2004. INCOME TAXES 1st Source recognized income tax expense for the three months ended September 30, 2005, of $4.71 million for an effective tax rate of 33.17%. For the three months ended September 30, 2004, 1st Source recognized an income tax benefit in the amount of $1.29 million for an effective tax rate of (63.92%). $1.16 million of this tax benefit was related to dividend received deductions claimed through amended tax returns for the years 2000 through 2003. For the nine-months ended September 30, 2005 and 2004, 1st Source recognized income tax expense of $11.97 million and $5.38 million, for effective tax rates of 23.93% and 32.68%, respectively. The effective tax rate rose in 2005 as a result of the 2004 tax benefit and the increase in pretax income. 19
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK There have been no material changes in market risks faced by 1st Source since December 31, 2004. For information regarding 1st Source's market risk, refer to 1st Source's Annual Report on Form 10-K for the year ended December 31, 2004. ITEM 4. CONTROLS AND PROCEDURES As of the end of the period covered by this report, 1st Source carried out an evaluation, under the supervision and with the participation of 1st Source's management, including 1st Source's Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of 1st Source's disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934) pursuant to Exchange Act Rule 13a-14. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, at September 30, 2005, 1st Source's disclosure controls and procedures are effective in accumulating and communicating to management (including such officers) the information relating to 1st Source (including its consolidated subsidiaries) required to be included in 1st Source's periodic SEC filings. In addition, there were no changes in 1st Source's internal control over financial reporting (as defined in Exchange Act Rule 13a-15(f)) during the third fiscal quarter of 2005 that have materially affected, or are reasonably likely to materially affect, 1st Source's internal controls over financial reporting. PART II. OTHER INFORMATION ITEM 1. Legal Proceedings. 1st Source and its subsidiaries are involved in various legal proceedings incidental to the conduct of their businesses. Management does not expect that the outcome of any such proceedings will have a material adverse effect on 1st Source's consolidated financial position or results of operations. 20
ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds ISSUER PURCHASES OF EQUITY SECURITIES <TABLE> <CAPTION> (a) (b) (c) (d) Total number of Maximum number(or approximate Total number Average shares purchased dollar value) of shares of shares price paid per as part of publicly announced that may yet be purchased under Period purchased share plans or programs the plans or programs - -------------------------------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> July 01 - 31, 2005 0 0 0 549,403 August 01 - 31, 2005 11,325 23.65 11,325 538,078 September 01 - 30, 2005 0 0 0 538,078 </TABLE> (1) 1st Source maintains a stock repurchase plan that was authorized by the Board of Directors on October 23, 2001. Under the terms of the plan, 1st Source may repurchase up to 1,038,990 shares of its common stock when favorable conditions exist on the open market or through private transactions at various prices from time to time. Since the inception of the plan, 1st Source has repurchased a total of 500,912 shares. ITEM 3. Defaults Upon Senior Securities. None ITEM 4. Submission of Matters to a Vote of Security Holders. None ITEM 5. Other Information. None ITEM 6. Exhibits The following exhibits are filed with this report: 1. Exhibit 31.1 Certification of Chief Executive Officer required by Rule 13a-14(a). 2. Exhibit 31.2 Certification of Chief Financial Officer required by Rule 13a-14(a). 3. Exhibit 32.1 Certification pursuant to 18 U.S.C. Section 1350 of Chief Executive Officer. 4. Exhibit 32.2 Certification pursuant to 18 U.S.C. Section 1350 of Chief Financial Officer. 21
SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. 1st Source Corporation DATE October 27, 2005 /s/CHRISTOPHER J. MURPHY III ---------------- ------------------------------------- Christopher J. Murphy III Chairman of the Board, President and CEO DATE October 27, 2005 /s/LARRY E. LENTYCH ---------------- ------------------- Larry E. Lentych Treasurer and Chief Financial Officer Principal Accounting Officer 22